Where Are Stock Prices Headed?

THE AUTHORS OF A GROUNDBREAKING BOOK SAY THE STOCK MARKET WILL SOAR OVER THE NEXT FEW YEARS. A PROMINENT ECONOMIST SAYS HE DOUBTS IT.

Kevin Hassett and James Glassman

Since 1982, the Dow Jones Industrial Average has climbed from 777 to above 11,000. Including dividends, the stock market as a whole has produced returns of more than 2,000 percent over this period. But, throughout this entire spectacular rise, financial experts on Wall Street, in the media and in academe have continually warned that stocks were already dangerously overvalued, or, at best, "fully valued."

From a traditional vantage point, stocks do now appear expensive. But what if traditional methods for valuing stocks are no longer valid? We believe the share price surge of the past two decades demonstrates not the insanity of investors but the inadequacy of the old stock pricing models.

Experts measure stock prices against particular yardsticks of history--especially price-to-earnings (P/E) ratios and dividend yields--and pronounce current prices far too high. But, over the past two years, your co-authors have developed another way to value stocks, and this model indicates that today's prices remain far too low.

How low? Our analysis finds that the proper value for the Dow is 36,000--today, not l0 or 20 years from now. Based on our model, P/E ratios of 100 (three to four times current levels) are justified for the market as a whole. In March 1998, we laid out our theory in an article in the Wall Street Journal. The Dow at the time was 8,782. Then in the summer, with the Dow at 7,500, we began writing our book. By the summer of 1999, the Dow had breached 11,000.

What's our logic? We begin with the two simple components of any investment--risk and return. Historically, stocks have provided a much higher return than alternative investments: an annual average of 11 percent over the last 73 years, compared with less than 6 percent over that same period for Treasury bonds.

Normally, one asset delivers a higher return than another because it is riskier. For example, relatively secure AT&T bonds were paying interest of 6.7 percent this year, while the bonds of Chesapeake Energy, a more shaky company, were paying 12.3 percent. The riskier company was forced by the market to pay that extra return--called a "risk premium"--in order to attract lenders.

But for stocks, there has always been a problem--known among economists as the "equity premium puzzle"--about the relationship between risk and return. When you look at data going all the way back to the nineteenth century, you find that stocks are really not any riskier than bonds in the long run. While the returns of stocks fluctuate from year to year, this volatility is canceled out over longer periods. Bonds, which can drop precipitously in value if inflation increases, have proven to be very risky investments in comparison.

In his book Stocks for the Long Run, Wharton School professor of finance Jeremy Siegel presents mounds of evidence on this subject and concludes, "Although it might appear to be riskier to hold stocks than bonds, precisely the opposite is true: the safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds."

For example, Siegel looked at every 20-year period from 1802 to 1997 and found that the worst such stretch for stocks produced average real (after-inflation) returns of 1 percent a year; for Treasury bonds it was minus 3 percent. "Stocks," he wrote, "in contrast to bonds or bills, have never offered investors a [negative] yield over periods of 17 years or more."

The puzzle that has baffled economists is this: Why should stocks produce returns that are so much higher if they are no more risky than bonds? The best explanation is that people have been irrationally fearful of stocks. They watch the short-term ups and downs and myopically lose sight of the fact that, in the long run, returns have been remarkably consistent--and positive. …

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